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Morningstar | Suncorp’s FY19 Should be OK, but New CEO Needs to Deliver Sustainable Future Earnings Growth

No-moat-rated Suncorp Group is at the crossroads--again, with a new CEO soon to be announced and a likely consequent change in direction for the group. The new CEO will inherit an underperforming bank and a general insurance business in Australia and New Zealand performing just OK. The past four years, including fiscal 2019, have not been particularly rewarding as far as earnings growth and shareholder returns go. Disappointingly, the current share price is broadly in line with mid-2015 levels, compared with the impressive 50% increase in key competitor, Insurance Australia Group’s share price over the same time frame. Based on Morningstar analysis, Suncorp’s total shareholder returns have been 4.5% per year for the past five years compared with Insurance Australia Group’s 12.7% per year return for the same period.

Suncorp continues to deal with a tough operating environment, with natural hazard costs above internal allowances, investment market volatility and unforeseen regulatory costs expected to impact the group’s fiscal 2019 results. Suncorp is due to release fiscal 2019 results on Aug. 7, 2019. No change to our AUD 14.50 fair value estimate at this stage and at current prices, the stock is fairly valued trading 9% below our valuation. Despite some concerns, the stock is an attractive dividend payer with a 6% forecast yield for fiscal 2019 and 2020, grossing to 8.5% after franking. We expect the unsustainably high fiscal 2019 payout ratio of 93% to decline to 80% in fiscal 2020 and 79% in 2021 with the dividend expected to increase to AUD 80 cents per share, or cps, in 2020 and AUD 86 cps in 2021. We think Acting CEO Steve Johnston will be appointed CEO and we are confident he can refocus and re-energise the group’s strategy and leverage the hard work already done on product, service, digitalisation, and brand, to kickstart earnings growth starting with modest revenue growth and improved productivity.

Acting CEO Johnston should be confirmed CEO as soon as possible, allowing him the authority to speed up the restructuring process and bring forward the insurer’s ambitious medium term guidance. Earnings guidance for fiscal 2019 was confirmed in late May to be in line with market expectations. Consensus estimates for fiscal 2019 are cash NPAT of about AUD 1.1 billion and fully franked dividends of AUD 74 cents per share. Our unchanged forecasts are cash NPAT of AUD 1.1 billion and total dividends of AUD 78 cps, including the AUD 8 cps special dividend from the sale of the life business to TAL Dai-ichi Life.

Suncorp’s struggle to generate anything like the impressive earnings growth needed, highlights the firm’s lack of an economic moat and the insurer’s board and senior management’s failure to set and deliver a business strategy to capitalise on its strong portfolio for brands and large market share in Australia’s general insurance market. At this stage, management’s medium term targets are unchanged, with 10% return on equity, 12% underlying insurance margin and 60%-80% dividend payout standing out, but these targets are subject to change depending on the new CEO.

Recent earnings performance in the Australian general insurance business has been patchy at best. A severe natural peril experience in first half fiscal 2019 was outside the control of management and damaged profitability. Second half fiscal 2018 results were impressive, and we expect something similar in second half fiscal 2019. The general insurance pricing cycle for business insurance continues to improve, or “harden” in insurance speak, benefiting premium revenue growth, even though unit growth is modest.

We are keen to see the first stage of the new CEO’s rebuilding plans, but major changes to current strategy would be expensive and disruptive. We see a more likely short term scenario to be working existing assets harder and making incremental changes to strategy. But volatile and expensive natural peril events could derail progress during the next few years despite management increasing natural peril allowances and reinsurance cover for 2019. Higher regulatory spend is an ongoing risk with management already increasing expected spend for fiscal 2019 by AUD 50 million or 55% to AUD 140 million. Elevated regulatory spend will likely repeat in fiscal 2020.

Suncorp Bank’s lending portfolio continues to struggle. Momentum is soft with total lending down by 0.5% over the March quarter, which translates to growth of 1.0% on a trailing-12-months basis to end March. Both periods lag the system rate of growth, which grew 2.5% over the March quarter and 6.0% over the 12 months to end March. This underperformance was led by a contraction in the important housing loan book, which contracted 0.7% over the March quarter and grew marginally by 0.8% on a trailing 12 month basis, versus growth of 0.5% over the March quarter and 3.5% on a trailing 12 months basis across the system.

A combination of price-driven competition and a continued slowdown in demand for credit weighed on the performance of the housing book, which is overweight in the Queensland and New South Wales housing markets. Nevertheless, we expect a slightly more positive outcome for Suncorp Bank’s fourth-quarter results, especially given short term wholesale funding costs continued to trend downwards. We like the quality of Suncorp Bank’s lending portfolio, which sits at healthy levels due to prudent risk management.

We expect the bank’s common equity Tier 1 ratio will be around 9.5% at June 30, 2019, exceeding its target range of 8.5% to 9.0%. While the common equity Tier 1 ratio trails the advanced accredited four major banks, Suncorp Bank’s capital levels continue to satisfy APRA’s lower capital threshold for banks utilising the standard risk weighting methodology.